The Impact of Minimum Wages on Wage Inequality and Employment in the Formal and Informal Sector in Costa Rica

William Davidson Institute Working Paper 479

America countries, this ratio has risen in the 1980s compared to the 1970s. We find a declining
trend in overall inequality (using three measures) over the 1980-1992 period. We also find that
the level of wage (earnings) inequality among covered sector workers is lower than among the
uncovered sector workers. Finally, inequality has declined more rapidly in the covered sector
than that in the uncovered sector.

Regression analysis reveals that at the median, a unit increase in the minimum wage
relative to the average wage in the industry is associated with: a) a reduction in wage inequality
in the covered sector of between 0.9 percent (using the Gini) and 1.7 percent (using the Theil
mean logarithmic deviation) and no effect on earnings inequality among the self-employed
(using all measures); b) an increase in the level of covered sector employment by 0.56 percent
and total employment by 0.35 percent, but has no effect on the number of self-employed; c) an
increase in the average number of hours worked per week by 0.14 percent in the covered sector
and 0.34 percent in the uncovered sector; and d) a raise in the percentage of covered sector
workers within an industry by 0.29 percent one year after the minimum wage is increased.
Hence, the Costa Rican government does appear to be accomplishing its goal and its policy also
seems to be assisting the reallocation of workers from the self-employed (informal) sector to the
covered (formal) sectors counter to the traditional view.

From a theoretical perspective, these finds are counter to the traditional competitive two-
sector models of the minimum wage. We interpret these findings as supporting the
monopsonistic and efficiency wage models of the labour market in those industries where the
ratio of the minimum wage to the average wage (“toughness”) is low but supports the traditional
models in those industries where toughness is high. Hence, workers in traditional industries
(with low average wages) are losing jobs whereas workers in more modern industries (with high

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